Fannie, Freddie given free pass to grow

By Al Yoon - Analysis

NEW YORK (Reuters) - Fannie Mae and Freddie Mac, the top providers of funding for U.S. residential mortgages, got a free pass from the government to grow their businesses on Wednesday.

Shares of the government-sponsored enterprises (GSEs) have both jumped about 40 percent since last Friday, recovering some of their steep declines after reporting record losses in recent quarters.

The about-face by investors in Fannie and Freddie resulted from the companies' regulator reducing the capital they must hold against assets, boosting their purchasing power by an estimated $200 billion.

For the GSEs' basic businesses, the move was a gift. The companies investment portfolios that provide most of their profit have been locked around $1.4 trillion for three years. Fannie Mae's current portfolio balance is down 20 percent from 2004 when capital issues forced it to pare its balance sheet.

"With less capital, the more they can grow," said Ed Walczak, a portfolio manager at New York-based Vontobel Asset Management, which owns a quarter-million shares of each GSE.

GSE purchases may also have an indirect benefit on the ailing U.S. housing market, he said.

Increasing portfolios may add up to 80 cents a share in earnings annually for Fannie Mae and Freddie Mac if they don't have to raise more capital, according to Paul Miller, an analyst at Friedman, Billings Ramsey in Arlington, Virginia.

But growth also makes the companies riskier, said Miller, who isn't budging on his "underperform" ratings.

Miller and other critics are wary of how Fannie Mae and Freddie Mac will deploy newfound capital in a housing market that by most estimates won't improve until 2009.

This has sparked worry since the companies reported record losses in recent quarters even when they were restricted from playing a larger role in housing.

"We believe credit losses will exceed the companies' guidance in 2008 and 2009, eroding capital" that has been won, UBS Securities' Eric Wasserstrom said on a research note.

Write-downs and losses related to assets in the portfolios and guarantee obligations led to a $2.1 billion, or $2.63 per share, loss for Fannie Mae in 2007. Freddie Mac's loss totaled $3.1 billion, or $5.37 a share.

Their earnings have a long way to go before matching the $4 billion-plus annual profit enjoyed during the rapid refinancing and low credit-loss period of the housing boom.

The Office of Federal Housing Enterprise Oversight amended its capital rules since the companies have completed, or nearly completed improvements to accounting and risk reporting that led to accounting scandals in 2003 and 2004.

The move appears to be a shift for the Bush administration that for years has cried that massive portfolios are a greater risk to the financial system than a help to the housing market.